Bear Markets a Silver Lining for Young Investors?

From the summer issue of the T. Rowe Price Report

Would you rather start investing for retirement during a bull market or a bear market?

After the historically poor performance of equities in the last decade — marked by two ferocious bear markets with overall losses greater than any other time since the Great Depression — some young investors might consider reducing or even eliminating their exposure to stocks.

However, they may be surprised to learn that, in the past, such downturns have presented investors with rare opportunities to benefit from healthy future returns.

A new study by T. Rowe Price shows that bear markets have provided a substantial advantage for investors decades away from retirement. The study found that those who began systematically investing in equities in past severe bear markets were significantly better off 30 years later than investors who began in bull markets. Naturally, this effect is even more pronounced if the bear markets were followed by big bull markets.

“Those who began investing at the start of this decade may be discouraged, but they could have two powerful forces in their favor: the cyclicality of markets and the ability to accumulate a lot of shares early in their career,” says Christine Fahlund, a senior financial planner with T. Rowe Price. “In the past, investors who were able to maintain their investment programs throughout a prolonged period of weak performance were poised to benefit when markets recovered.”

Bear or Bull?

The new analysis examined four hypothetical investors who each contributed $500 per month (15 percent of a $40,000 annual salary) into a retirement account invested in a portfolio that replicated the S&P 500 index over a 30-year period. One investor started in 1929, one in 1950, another in 1970 and one in 1979.

A hypothetical $10 share price was used at the beginning of each period and was indexed to follow the actual monthly fluctuations of the S&P 500. All dividends were reinvested in additional shares.

The two investors who began making contributions in 1929 and 1970 started just before two of the worst bear markets in modern history.

Like today’s young investors, they may have felt discouraged after their first decade; the S&P 500 had an annualized total return of -0.9 percent from 1929 to 1938 — the second-worst 10-year period in history — and only 5.9 percent in the recessionary 1970s.

By 1979, for example, mainstream thinking had turned so cynical that BusinessWeek magazine proclaimed “The Death of Equities” on its cover.

However, there were two silver linings for these bear market investors.

First, they had the opportunity to buy at low prices, on average, and thus accumulate more shares early on, putting them in a better position to gain from future bull markets.

Second, by making systematic investments and reinvesting dividends, they ended their first decade of investing with modest returns.

Their total contributions of $60,000 over the first 10 years grew, respectively, to $88,255 by 1938 and to $86,047 by 1979. (Note: An investor who owned fewer securities compared with the S&P 500 may not have done as well. Also, the return earned for a systematic investment plan is different than the return earned for someone who invests a lump sum at the beginning of the period and simply reinvests dividends.)

The two other investors had a very different experience. By starting in 1950 and 1979, they were on the verge of two of the most rewarding decades for equity investing.

The S&P 500 returned 19.4 percent annualized from 1950 to 1959 and 16.3 percent from 1979 to 1988. Their $60,000 in contributions by the end of those decades grew to $152,359 and $137,370, respectively.

However, they were accumulating fewer shares at a higher average cost during these robust decades. Moreover, their average returns over following decades were much lower than the returns earned over following decades by the other two investors.

Thus, despite their strong starts, their ending balances after 30 years were remarkably less than half those of the two investors who began investing at the start of bear markets.

The Great Depression decade of the 1930s marked the beginning of the worst 30-year period for equity investing. Yet the S&P 500 provided a respectable 8.5 percent annualized return from 1929 to 1958. The investor who stuck to this systematic investment plan over that 30-year period ended up with a total return of 960 percent.

The investor who started in 1970 had a remarkable total return of 1,753 percent over 30 years because he later benefited mightily from the unusually strong returns earned in the 1980s and 1990s. In sharp contrast, the investors who began in the bull market decades (the 1950s and 1980s) earned less than 400 percent over 30 years.

“However, our research shows that many who began investing in horrific markets significantly benefited from that over the long run.”

Sequence Matters

To further illustrate the potential opportunity of bear markets, the study also examined how returns could differ if a bear market or weak decade is followed by a bull market or strong decade, and vice versa.

For example, an investor who contributed $500 monthly from 1970 to 1989 ($120,000 in total) in a portfolio replicating the S&P 500 index ended up with an account value of $589,707. The index had an annualized return of 11.5 percent during this period.

But what if the decades were reversed — with the modest performance of the 1970s (including the steep 1973-1974 bear market) following the 1980s bull run? In that case, the account value at the end was much less, $358,972, even though the index’s annualized return for the 20-year period was still 11.5 percent.

Similar results were produced when the study compared the 19-year period from 1990 to 2008. The investor who began contributing in 1990 ended up with much less than half the balance compared with what he or she would have had if the decades were reversed — the weak returns from 2000 through 2008 followed by the exuberant gains from 1990 through 1999.

“The sequence of returns matters more than people may think,” Ms. Fahlund says. “Starting systematic contributions to your retirement account during a bear market can be tough, but it may give you the opportunity to purchase a larger number of shares for the same amount of money, which could prove very beneficial by the time you retire.”